Economic bubble

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An economic bubble (sometimes referred to as a "market bubble", a "financial bubble", or a "speculative mania") refers to a market condition in which the prices of commodities or asset classes increase to absurd or unsustainable levels (that no longer reflect utility of usage and purchasing power). It occurs when speculation in the underlying asset causes the price to increase, thus encouraging even more speculation. The bubble is usually followed by a sudden drop in prices, known as a crash or a bubble burst. Both the boom and the bust phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate chaotically, and become impossible to predict from supply and demand alone.

Economic bubbles are generally considered to have a negative impact on the economy because they cause misallocation of resources into non-optimal uses. In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise. A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.

Another important aspect of economic bubbles is their impact on spending habits. Market participants with overvalued assets tend to spend more because they "feel" richer (the Wealth Effect). Many observers quote the housing market in the United Kingdom, Australia, Spain and parts of the United States in recent times, as an example of this effect. When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of poorness and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. Therefore, it is imperative for the central bank to keep its eyes on asset price appreciation and promptly take preemptive measures to curb high level of speculative activity in financial assets.

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The cause of bubbles is often disputed although some experts believe that the cause of bubbles can be explained by the "greater fool's theory." The greater fool's theory explains the behavior of a perennially optimistic market participant (the fool) who buys an overvalued asset in anticipation of selling it to another rapacious speculator (the greater fool) at a much higher price. The bubbles continue as long as the fool can find another (greater) fool to pay up for the overvalued asset. The bubbles will end only when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price.

Other experts argue that the cause of bubbles is excessive monetary liquidity in the financial system. Excessive monetary liquidity (a.k.a. easy credit) potentially occurs while central banks are implementing expansionary monetary policy (ie. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate. Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. The bubbles will burst only when the central bank reverses its monetary accommodation policy and soaks up the liquidity in the financial system. The removal of monetary accommodation policy is commonly known as a contractionary monetary policy. When the central bank raises interest rates, investors tend to become risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.

Still others say that economic bubbles are mainly driven by the greed and irrational exuberance of overly bullish investors. They argue that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to capture those abnormal rates of return. Overbidding on certain assets will at some point result in inadequate rates of return for investors, only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments. This in return may reflect as shortage of skilled labour causing a vicious circle since young skilled workers tend to go abroad for better financial oppurtunities due to a halt in the industry. The economic downtime however stagnates once a dedicated pool of workers is allocated but this obviously comes at the cost of high service rates. Australia from the last three years has been facing such a problem. Although it is a stable economy, young skilled labour follows a trend to come down to the United Kingdom and other European countries on work visas. This creates a demand and supply gap chain which is then fullfilled by allowing immigration into the country on suitable basis. The issue is readily addressed as a 'Floating Economic Bubble' which strains the economy for that particular time but eventually phases out. During the period, the Australian Government takes appropriate measures to avoid the outsourcing of any business and therefore implements strict control over labour shortage both in the skilled and highly skilled feilds. Since this phenomenon creates a high assumed charge over exact prices
and rates, a 'Constant Economic Bubble' may emerge as happened in 2004 when National Australia Bank lost A$360 million resulting from foreign currency trades undertaken by 4 option traders.

Due to this phenomenon, some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles. Others take the view that there is a "fundamental value" to an asset, and that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value. There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic actors. Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals".